How to Become a Savvy Investor in Sector ETFs

If you buy a single stock, your fate rests on the ups and downs of that one company. If you want to moderate this risk but still aim for your target, investing in an exchange traded fund that focuses on a particular sector is one way to go. "For many stock-pickers, sector ETFs make sense," says Robert Holderith, president and CEO of Emerging Global Shares. "Imagine that you really like Apple (AAPL) and maybe two other gadget names. You can pick one or two stocks but be saddled with stock-specific risk." A tech-sector ETF would offer broader exposure, he says.

Holderith says an alternative is to put a portion of this decision into stocks and another potion in the relevant sector ETF. This will "provide diversification, yet in a practical, transparent, liquid, low-cost manner," he says.
How to Choose?

The appeal is the ability to gain more exposure to sectors you favor and to avoid exposure to sectors you don't like, explains James Shelton, chief investment officer of Kanaly Trust.

However, with the existence of sector ETFs for just about everything, how do you begin to choose? As elsewhere in the investing universe, "Portfolio holdings are supposed to match your short-term and long-term financial objectives," says Holderith.

Holding sectors for longer term (more than one year) means tailoring the risk/return profile. Generally, this means defensive exposures (less volume, higher yield) to more risk-averse portfolios and more cyclical exposures (higher volume) to higher-growth portfolios, he adds.
Go With What You Know

Limit yourself to a few asset classes that you understand. Decide what percent of your portfolio would be in each asset class, assuming normal, average, never-changing and ideal conditions, explains Rick Ashburn, chief investment officer of Creekside Partners.

Look at those few classes from a valuation perspective. Forget charts showing recent price activity. You have to develop a point of view about whether you can buy those assets cheap, fair or expensive. As a secondary matter only, look at the business cycle and general economic conditions. "Are we topping out [high Fed rates], or are we around a bottom [low Fed rates]?" asks Ashburn.

Diversification is different from bias. Most U.S. investors already have broad U.S. equity exposure via a mutual fund, ETF or broad portfolio of stocks. When they buy a domestic sector ETF, say technology, they're likely getting more of something they already have, says Holderith.

"So it's a bet to double down on that sector," says Holderith. "It's not diversification." If an investor likes tech, say, but wants to diversify, they should add something they don't already have -- and verify that it does indeed add diversity to the portfolio, he says. "This means buying something like a small-cap tech fund, a private-equity tech fund or an emerging-market tech fund," he adds.

The point, says Mike Feser, president of Zecco Trading, "Is not to put all your eggs in one basket."
Avoid Chasing "Hot" Sectors

Many sector ETFs have yet to build a following. In these trending markets with high correlations -- meaning they tend to move together -- the easy money has been made by buying the whole market (S&P 500, MSCI EAFE, MSCI Emerging Market). If the forward-looking environment is more difficult, sector investing will gain popularity. But if markets continue to trend, they may not, predicts Holderith.

Forget the herd. Don't chase "hot" sectors. "They will tend to peak in price just as the uptrend wanes. That is why investors need to heed market buy and sell signals so that they do not buy overpriced ETFs at the wrong time," says Leslie Masonson, author of Buy -- Don't Hold: Investing with ETFs Using Relative Strength to Increase Returns with Less Risk.

Ashburn is of similar mind. "The one thing you do not want to do is buy ETFs from small, oddball sectors and single countries because they've been doing well lately. That is known as second-guessing, and guessing is never a good investment strategy."

Investigate ETF's Liquidity

Research the liquidity of the ETF. Some funds are launched with as little as $2.5 million in assets. For these smaller or newly launched ETFs, liquidity can be an issue, which can lead to wide bid-ask spreads, says Joe Jennings, an investment director with PNC Wealth Management.

Make sure you know what will make you sell the ETF before you purchase it. "It is important to be disciplined when trading sectors," says Frank. If you have a well-tested sector trading model, make sure you stick to it, he adds.

Another distinction is the introduction of thematic funds. Such funds focus on sectors like water, nuclear power or infrastructure. Just this week, Emerging Global Shares launched the China Infrastructure Index Exchange-Traded Fund (CHXX), the first ETF focused solely on the infrastructure sector in China.

Sector ETFs Can Cost You

In reality, says Holderith, these funds combine various subindustries into a common theme. These are not to be confused with classic sectors, which are rather standardized, he adds.

Remember, too, if only a few companies in a particular sector are outperformers, then you're getting the good with the bad. For instance, only a handful of financials in 2008 weren't severely hurt by the credit crisis, points out Shelton.

Sector ETFs are typically more expensive than broad-based ETFs, even if they're still relatively cheap. The management fee could be double when compared to a market ETF, he adds.

Manage Your Weighting

Be real about how much time you can devote to sector ETFs. "Investing in sectors is not a part-time activity. Markets move quickly, and positions need to be monitored continuously," says Frank.

You'll need to manage your weighting because you could have major deviations in your portfolio relative to the entire market, says Shelton. "Be aware of that."

Many investors who use other strategies are actually making sector calls. For example, when an investor wants exposure to Russia, they usually do so because of a determination on oil and gas markets. For Taiwan, it's info tech. "Investors need to think if their process is determined more by sectors, and if so, they need to consider pure sector-oriented instruments to implement that decision," says Holderith.

Know Your Risk Tolerance

Be cognizant of the risk that you might be bringing to your portfolio. Your overall exposure to the different sectors relative to the overall market need to be considered. For instance, you could purchase the index ETF and rest assured that you aren't over- or underexposed. This is the case with a sector ETF, says Shelton.

Lastly, says Holderith, "Sector allocation as a strategy is one well accepted way to provide 'alpha' beyond market returns. If defensively oriented, there is the potential for smoother returns in the long run. If aggressive, there's the potential to exploit the ebb and flows of the economic cycle."